In fundamental analysis a trader uses fundamental indicators to help gauge the attractiveness of a currency and then use that information to trade.
In simplest terms, traders and investors use this data to gauge strength of an economy and then buy/sell that country’s currency against its rivals.
A stronger economy will favor the country’s currency, while a bad economy would usually correspond with a declining currency.
Governments, institutions, and private companies publish reports and data about the macroeconomic picture – known as “fundamental indicators” or “macro” indicators.
There are many different fundamental indicators that cover all the various sectors of an economy:
- Consumption – Retail Sales, Personal Spending, Factory Orders, Car Sales, Housing Sales
- Labor Market – Employment Change, Unemployment Rate, Wages
- Manufacturing/Services – Industrial Production, Purchasing Managers Indexes, Shipment Orders
- Capital Flows – Trade Balance, Current Account
- Housing – Home Sales, Home Prices, New Home Constructions
- Inflation – Consumer Prices, Producer Prices, Import Prices
In addition to fundamental indicators and news reports, fundamental analysis tries to asses the complex interplay between equities, commodities, currency & bond markets to help give an advantage in anticipating whether a currency will rise or fall.
Investors Seek Higher Yields in Foreign Lands
In a longer term time frame, a trader or investor is trying to rate the relative strength of different country’s growth potentials as well as forecasts for inflation and interest rates as these are key to determining what kind of return an investor can get from investing within a country’s borders.
In the most broadest terms, when an investor is searching for a place to invest money he or she can recieve higher yields in a country with higher interest rates. That can be done by buying bonds, deposits and other investments in that country. As foreign investors move their money from their home country to another country they need to exchange for that country’s currency, increasing demand and therefore adding upward pressure to the price of that currency.
For example, after the financial crisis in 2008, the United States lowered interest rates to near zero, while Australia, after a period of lower rates (3.0%), began raising interest rates in late 2009 bringing them to 4.75% in 2010, as its economy, thanks to strong commodity exports and prices, skirted a recession. This difference in interest rates between the 2 countries is called the “yield differential” or “interest rate differential”. This rate differential helped the Australian Dollar to gain on the US Dollar during that time period.
Fundamental Analysis in the Short Term
Fundamental analysis can be carried out both in the short-term and in the long term. An aggressive short term trader, or scalper, may try and trade the price action directly after news events which can be volatile if the official figures differ from the market’s expectation.
For example, in the picture below, the GBP/USD pair fell sharply following the release of GDP data that showed the economy contracting 0.5% during the 4th quarter of 2010, when expectations had it increasing 0.5%. That was a big surprise to analysts, traders, and investors and therefore it In the short term that caused the pair to drop from a level near 1.5950 to 1.5760 a move of around 200 pips.
In a longer term example the start of “Quantitative Easing” by the US, in which the Federal Reserve began printing money to buy long term bonds, was an event that severely weakened the USD as it put the Federal Reserve at an extremely loose monetary policy stance. The USD succumbed to a months long decline following that announcement. With the global recovery beginning around the same time, investors and traders used cheap USD to buy higher yielding currencies and commodity linked currencies throughout the rest of 2009.
There are also many other factors that can set off both short-term and long term moves that go beyond the release of fundamental indicators. As mentioned before, in fundamental analysis a trader will follow a country’s equity and bond markets to get extra information regarding the business cycle and investor intentions.
A Primer on Investor Sentiment
Fundamental releases will be “priced into” the stock and bond markets of a country and therefore serve as a barometer for investor sentiment. This investor sentiment is also commonly referred to as “risk appetite”/”risk aversion” or “risk-on”/”risk-off” trading.
When investor sentiment is strong, say after the release of positive data from the economy or from better corporate earnings, traders would like to buy stocks as they search for better returns than they could get from buying safe assets like government debt. Investor sentiment is also a way to describe the willingness of investors and financial institutions to seek higher returns or higher yields, even if it means taking on more risk.
Investors and financial institutions rely on borrowing to facilitate a lot of their transactions and positions. In the currency markets, during times of risk appetite, investors and financial institutions will borrow money in a country with a low interest rate and use that borrowed money to buy higher yielding assets abroad.
During those times, countries with higher interest rates benefit as investors are on the “hunt for yield” and buy their assets. Therefore investor sentiment is also a measure of the willingness to borrow of institutional investors.
When these investors unwinds their original positions they pay back the original loan with the low interest rate they owe and pocket the difference from the higher interest rate they collected form parking that money in a higher yielding asset in what is known as “carry trade”.
This carry trade strategy works as long as the exchange rate risk does not outweight the benefit of the “carry”. In other words, if the exchange rate moves against the trader, it should not be enough to outweigh the difference in interest rates that the investor is collecting. Usually, currencies with higher interest rates are in those countries considered emerging markets or countries tied to commodities and global growth. When there are strong concerns about global growth then these currencies can weaken.
Each currency has some relationship to the changes in investor sentiment, mainly depending on where they fall in the spectrum of low to high interest rates.
This is a simple overview of the basics behind fundamental analysis and what drives investor sentiment, but much more explanation is needed in order to point out the intricacies inherent in forex trading and I will follow up this intro with more fundamental analyis lessons going forward.
Chief Market Analyst